Document Reference: S7003 - United Utilities · 2018. 9. 1. · Chapter 9: Supplementary Document -...

Evidence of financeability Chapter 9: Supplementary document

Document Reference: S7003

This document sets out the detailed evidence and calculations that support our financeability assessment as set out in the main submission document.

United Utilities Water Limited

Chapter 9: Supplementary Document - S7003 unitedutilities.com

Contents 1 Financeable on both a notional and an actual company basis ............................................................................ 3

1.1 Business plan assured as financeable by our board .................................................................................... 3

1.2 Goldman Sachs has provided assurance on financeability to our board .................................................... 3

2 Our financeability assessment approach ............................................................................................................. 4

2.1 Tools to mitigate financeability ................................................................................................................... 5

2.1.1 Impact of the regulatory model and real world financeability metrics .................................................. 5

2.1.2 Justification for use of PAYG ................................................................................................................... 6

2.1.3 Conclusion to resolution of financeability constraints ............................................................................ 7

3 Debt financeability: Maintaining efficient access to debt capital markets .......................................................... 7

3.1 Targeted financial headroom set at A3/BBB+ credit rating for the actual company .................................. 7

3.2 Targeted financial ratios and thresholds ..................................................................................................... 9

3.3 Rating agency and Ofwat model financial ratio differences and the impact on thresholds ..................... 10

3.3.1 S&P: FFO to net debt threshold calculation: ......................................................................................... 11

3.3.2 Moodys: Adjusted interest cover threshold calculation: ...................................................................... 12

3.3.3 Moodys: Gearing threshold: ................................................................................................................. 13

3.3.4 S&P: Interest cover threshold: .............................................................................................................. 13

3.3.5 Moodys: RCF to net debt threshold: ..................................................................................................... 14

3.3.6 Moodys: RCF to capex threshold: ......................................................................................................... 14

3.3.7 Overall threshold position: ................................................................................................................... 14

3.4 Debt financeability assessment – notional company ................................................................................ 14

3.4.1 Financeability constraint 1: FFO to debt ............................................................................................... 15

3.4.2 Financeability constraint 2: Adjusted interest cover ............................................................................ 16

3.5 Debt financeability assessment – actual company ................................................................................... 17

4 Equity financeability: Maintaining a healthy level of public equity investment ................................................ 18

4.1 Equity financeability assessment – notional company .............................................................................. 18

4.2 Equity financeability assessment – actual company ................................................................................. 19

5 Ensuring each price control can individually fund its operations ...................................................................... 20

5.1 Wholesale price controls – notional company .......................................................................................... 20

5.2 Wholesale price controls – actual company .............................................................................................. 21

5.3 Residential retail price control – actual and notional company ................................................................ 21

6 Appendix 1: Adjusted interest cover ratio ......................................................................................................... 23

Copyright © United Utilities Water Limited 2018 2


1 Financeable on both a notional and an actual company basis

1.1 Business plan assured as financeable by our board Our business plan as set out in our main submission document is financeable on both a notional and an actual company basis. Our board has provided a clear statement of assurance on this, with appropriate supporting evidence, in its assurance statement provided in document C0011 stating:

“The business plan is financeable on both the notional and actual capital structures…The Board has targeted credit ratings of Baa1 with Moody’s and BBB+ with Standard and Poor’s, for the notional company which corresponds to credit ratings of A3 with Moody’s and BBB+ with Standard and Poor’s for the actual company. These provide a degree of headroom above the threshold for investment grade and enables us to maintain efficient access to the debt capital markets throughout the economic cycle. The Board has assessed the financeability of the business plan under both the notional and actual capital structures and has reviewed the supporting independent assurance undertaken.”

As explained further in 3.4 below, we have targeted different ratings for the notional and actual companies. This is because the cost of capital and index-linked debt assumptions for the notional company do not enable a rating above Baa1 with Moody’s, which we assess to be the absolute minimum needed to be financeable. Whereas our actual company benefits from a higher proportion of index-linked debt and low embedded costs of debt enabling a higher rating of A3 with Moody’s, which we assess to be a tight but more resilient financeable position.

Our Board’s financeability assessment has been supported by the evidence set out in Chapter 9 and Chapter 4 of our AMP7 business plan along with independent assurance from Goldman Sachs’ independent review of certain financial information (see 1.2 below).

1.2 Goldman Sachs has provided assurance on financeability to our board

In support of our financeability assessment, we asked Goldman Sachs to undertake an independent review of certain financial information that formed the basis of our board’s financeability assurance. Goldman Sachs based their review on our proposed financial ratios, calculated in line with Ofwat’s ‘alternative calculation’. Goldman Sachs did not contribute to the preparation, modelling, or derivation of these metrics. In the resultant letter to our board (supplementary document T7003) Goldman states:

“Based on the actual capital structure, in the event that UUW's projected financial metrics are achieved, in our view S&P and Moody's are likely to rate UUW at BBB+ and A3, or higher, respectively.

Based on the notional capital structure, in the event that UUW's projected financial metrics are achieved, in our view S&P and Moody’s are likely to rate UUW at BBB+ and Baa1, or higher, respectively.”

Goldman expand further to state:

“On the assumption that UUW retains a BBB+/Baa1 rating (or better), in our view based on historical and current market conditions, there have been few periods in recent years when a UK regulated water business with BBB+/Baa1 ratings (or higher) would have had limited or restricted access to the debt capital markets”

Whilst a copy of this assurance letter has been provided as part of our business plan submission (document reference T7003), it is subject to contractual arrangements between UU and Goldman Sachs that allow us to share a copy with Ofwat but not with other third parties. Therefore this letter is provided to Ofwat on the basis that it should not be published or shared further.



2 Our financeability assessment approach It is in the best interests of all stakeholders to maintain a robust capital structure and stable credit ratings profile, given our significant financing requirements across AMP7 and need to access finance at an efficient cost. As such, our financeability assessment targets the maintenance of appropriate credit ratings and investor returns to enable us to finance our activities, albeit with limited headroom, in order to achieve a stretching, fair and balanced plan.

In concluding whether our plan is financeable we have evaluated both our notional and actual company’s financial metrics from both an equity and a debt perspective. We have:

• assessed whether the credit ratios at the appointed business level are sufficient for us to achieveappropriate credit ratings that enable us to finance our activities

• assessed whether underlying returns in the appointed business are in line with the cost of capital and thatdividend cover is adequate and sustainable; and

• performed high level headroom checks at the individual price control level

We have targeted credit ratings of Baa1/BBB+ for the notional company and A3/BBB+ for the actual company. We consider maintaining A3/BBB+ ratings provides an appropriate level of headroom for AMP7 as such ratings offer robust access to funding (including in times of market disruption) and efficient debt financing costs, compared to lower ratings (see 3.1 below for further evidence supporting our targeted credit ratings level). Our experience of operating with A3/BBB+ ratings over most of the past three AMPs has proven such ratings offer robust access to debt markets in a variety of conditions and has proven acceptable to our customers. Whilst we assess A3/BBB+ to be the most appropriate ratings for a UK water company, we do still consider that Baa1/BBB+ ratings are just about financeable, but with a lower degree of financial resilience.

For the purposes of our financeability assessment below, we have had to calculate a number of revised financial ratios to address certain discrepancies in the financial model (P0004), which have been included as UUW proposed financial ratios in table App10. These revised financial ratios follow the same ratio calculation methodology as Ofwat’s financial model, but adjust for discrepancies in the underlying numbers, for the following issues (also see our table commentary to App10 in P0005 for full details):

• FFO:Debt and FFO:Debt (alternative version) – Ofwat’s model deducts ongoing pension costs aspart of the measure. However, this value is already included within opex, and so the additionaldeduction of pension costs acts to double count this value, artificially reducing the value of theseratios. Our proposed revised calculations are identical to Ofwat’s financial model, except forremoval of the duplicative deduction of pension costs

• Adjusted interest cover (alternative version) – The published model is seeking to “look through”adjustments to PAYG and RCV run off, but the sign convention for the wholesale operatingexpenditure is the reverse of what would be expected. Our proposed revised calculation simplychanges the sign convention of this line in addition to removing the duplicate pension costsdeduction as described above

• Dividend cover – The approach to depreciation in the financial model is a simplified one, utilising asingle asset life for each price control. We have assumed asset lives consistent with the correctoverall value of depreciation projected to be incurred over AMP7, however, we forecast that ourdepreciation profile will be much flatter than that calculated within Ofwat’s model and thismaterially impacts the result. Our proposed revised dividend cover measure adjusts the calculationto reflect the true depreciation profile, which it is not possible to replicate in Ofwat’s model

In our financeability assessment in sections 3 and 4 below, we have taken our adjusted ratios as the basis for our assessment and consider that this is the appropriate way to conduct the financeability assessment, in line with the intention of the methodology, having adjusted the outputs of the financial model to adjust for unintended issues arising from the design and functionality of the model.



In addressing any gap between the revenue requirements on a cost recovery building block basis and those based on our view of financeability, we have concluded that using PAYG levers is the most appropriate tool. This is because equity injections are only appropriate where gearing or investment needs are high. This is not the case in our business plan where cash flow metrics have weakened, not because gearing is increasing above the notional assumption, but because the proportion of the nominal return that is earned as cash flow has decreased over recent AMPs. Dividend cuts offer little mitigation to cash flow metrics particularly at the start of an AMP period, whereas PAYG ratios directly address cash flow weaknesses caused by lower real returns at PR19 and can be used whilst still maintaining a stable capital structure and responsible levels of dividend distribution (see 2.1 below for full details).

2.1 Tools to mitigate financeability In looking to resolve financeability constraints we have considered various options including (i) raising new equity; (ii) reducing dividends; and (iii) revenue advancement through PAYG adjustments.

As explained in 3.4 and 3.5 below, the principal financeability constraint is the Standard and Poor’s FFO to Debt ratio, which for a conventionally financed company (securitised, high leverage companies have different constraints) must be maintained at or above 9.0% for the company to retain a BBB+ credit rating.

2.1.1 Impact of the regulatory model and real world financeability metrics

The regulatory building blocks approach to determination of revenue results in a revenue allowance that includes a real return on the RCV asset base with the inflation return being received as an RCV uplift. While the real return forms part of reported revenue reflected in the financial statements, the inflation return does not.

This creates a mismatch within the financial statements which reflect the real return on the RCV asset base in revenue but the full nominal cost of debt in interest expense. As a consequence, this depresses the level of reported FFO, adversely impacting the FFO to debt ratio. This impact is exacerbated at PR19 due to the lower levels of real returns with the real cost of debt (RPI stripped) representing just 31% of the nominal cost compared to 47% at PR14, although the transition to 50% CPIH indexation offsets much of this impact.

As the issue relates to the level of reported FFO rather than the level of debt, the most appropriate resolution to this issue should focus on supporting FFO while ensuring that the capital structure remains sustainable (as evidenced by the debt to RCV gearing).

The example in the following section shows how each of the three options resolve the financeability constraint in light of the consideration above.



2.1.2 Justification for use of PAYG The table in figure 1 shows a simplified1 illustrative example of a hypothetical company with a base plan where FFO to debt is at 8.6% on average over the price control period and Debt to RCV gearing is stable at 60%. It then shows the extent of adjustments needed under the three options considered to resolve the financeability constraint such that FFO/debt must be maintained at or above 9.0% on average over the price control period.

Table 1: Simplified, Illustrative example of options to improve FFO/Debt Base Equity injection Dividend reduction Increase FFO

Required change £320m T0 equity injection £107m p.a. reduction £22.5m p.a. increase

Average FFO (£m) 619 619 619 642

Average Debt (£m) 7,200 6,880 6,879 7,133

Average FFO/Debt (%) 8.6% 9.0% 9.0% 9.0%

AMP exit Debt (£m) 7,200 6,880 6,665 7,088

AMP exit RCV (£m) 12,000 12,000 12,000 11,888

Amp exit Debt/RCV (%) 60.0% 57.3% 55.5% 59.6%

(i) Equity injection As equity injections only impact debt (and not FFO) a large equity injection is required at the start of the price control to enable resolution of the FFO/Debt financeability constraint. To improve the FFO/debt metric by c0.4% would require an equity injection of c£320m, despite the base plan being in line with the notional company gearing of c60%. The impact of resolving the FFO/Debt financeability constraint in this way results in an inefficient capital structure with debt to RCV gearing reducing to an exit level of c57%.

(ii) Dividend reduction As with equity injections, dividend reductions only impact debt (and not FFO) meaning a large reduction is required annually to enable resolution of the FFO/Debt financeability constraint on average over the price control. This results in FFO/Debt increasing through the period from the 8.7% in year 1 to 9.3% in year 5. To improve the FFO/Debt metric by c0.4% on average over the price control period would require an annual dividend reduction of c£107m p.a. despite the base plan being in line with the notional company gearing of c60%. The impact of resolving the FFO/Debt financeability constraint in this way results in an inefficient capital structure with debt to RCV gearing reducing to an exit level of c55%.

(iii) PAYG increase to FFO A PAYG increase to revenue directly increases reported FFO and also results in a reduction to the level of reported debt. As a change to FFO impacts the ratio around 11x more than the same change to debt in the short term, this option has a material improvement to the FFO/Debt financeability constraint. To improve the FFO/Debt metric by c0.4% on average over the price control period would require an annual PAYG advancement of c£22.5m p.a. The impact of resolving the FFO/Debt financeability constraint in this way results in an capital structure with debt to RCV gearing remaining broadly stable with an exit level of c60%.

However, amending PAYG ratios is not an effective tool in addressing issues with adjusted interest cover as this is explicitly stripped out in Moody’s version of the ratio and therefore very limited options are available to address adjusted interest cover based financeability constraints.

In summary, the only option which resolves financeability whilst maintaining efficient capital structure is option iii, i.e. to advance PAYG to increase FFO.

1 Note that this simplified example does not consider second order differences, e.g. changes in interest due to differing levels of debt or cash flow. Copyright © United Utilities Water Limited 2018

6


2.1.3 Conclusion to resolution of financeability constraints

In section 2.1.1 we explained the reasons as to why the financeability constraint arises and the key features likely to be required of any solution.

In section 2.1.2. we have considered a simplified illustrative example of a hypothetical company to show how the three options to resolve the financeability constraint would impact the company and how effective these options are in addressing the considerations set out in section 2.1.1.

This demonstrates that the most appropriate solution to resolving the financeability constraint is the use of PAYG advancement to boost FFO and mitigate the mismatch created by the regulatory model, which is compounded by the extremely low real rate environment. The example shows that the capital structure remains sustainable for the future with RCV gearing remaining stable and our customers support this approach (see chapter 9, section 9.5 of our AMP7 business plan).

Therefore in our financeability assessment set out below, we have accelerated £102m through adjustments to the PAYG ratios as detailed in chapter 9, section 9.6 of our AMP7 business plan. Without the £102m PAYG advancement the notional company’s FFO to debt and FFO to debt (alternative) ratios would be below the 10% and 9% thresholds respectively and would not be financeable. As shown in 3.4 below, this advancement is the minimum needed to ensure financeability of the notional company with FFO to debt ratios being set to be just at the minimum thresholds during AMP7. While our actual company is slightly better placed as it benefits from low costs of embedded debt and a higher proportion of index linked debt, the advancement serves to provide limited but essential headroom as the FFO to debt ratios remain very tight for most years of the AMP (see section 3 below for full details).

This advancement will enable us to maintain strong credit ratings enabling efficient access to the debt capital markets, which should benefit customer bills over the long-term, whilst recognising that there will be a very small increase on the average customer bill across AMP7. This is the responsible thing to do to underpin bill affordability over the long-term and our customers research indicates that customers are supportive of smoother bill profiles and the relatively minor bill impacts of this adjustment enjoy very high levels of customer acceptability (see Chapter 9 of our AMP7 business plan for more details).

3 Debt financeability: Maintaining efficient access to debt capital markets

3.1 Targeted financial headroom set at A3/BBB+ credit rating for the actual company

We have assessed our appointed business’ forecast credit metrics against targeted credit ratings of A3 with Moody’s and BBB+ with Standard and Poor’s (S&P) for the actual company.

These targeted credit ratings are unchanged from our AMP6 target providing an appropriate level of financial headroom for AMP7 that should give an adequate level of resilience. Our experience of operating with ratings of A3/BBB+ over most of the past three AMPs has proven that such ratings offer robust access to debt capital markets in a variety of market conditions. These ratings targets have also proven to be acceptable to our customers, who both supported our business plan proposals at PR14 and support our current business plan proposals at PR19 which were both formulated including the A3/BBB+ ratings target.

A3/BBB+ ratings offer robust access to funding (including in times of market disruption) and efficient debt financing costs compared to lower ratings, which remains important given our ongoing significant financing requirements. The targeted ratings and the access they give to funding are also a supporting element of our financial resilience and long term viability (see Chapter 4, section 4.7 of our AMP7 business plan for more details of our financial resilience).



To evidence the impact of ratings on market access and financing costs we have included charts below which show periods of market disruption (Figure 1) and how our credit spread and the iBoxx GBP A and BBB index spread to gilts reacted (Figure 2). These graphs show that during periods of market weakness (highlighted in red), our credit spread reacted similarly to the ‘A’ band corporate index, whereas the ‘BBB’ band corporate index (which includes lower rated credits than us) widened materially more. This indicates that at times of market disruption, access to funding by corporates in the BBB rated index might be more problematic and is likely to be materially more expensive.

Figure 1: Chart showing periods of market disruption, Source: Goldman Sachs and Bloomberg as at 20 July 2018

Figure 2: Chart showing our credit spread versus A and BBB rated sterling corporate credit, source: Goldman Sachs and Bloomberg as at 20 July 2018

Additionally our target ratings of A3/BBB+ are in line with assumptions underlying Ofwat’s indexation mechanism for the new debt portion in the cost of debt allowance.

Ideally, we would have targeted an A3/BBB+ credit rating for the notional company, as we believe that gives a more resilient financeability assessment. However, as described in more detail in 3.4 below, whilst the notional company gearing is comfortably in A3 territory, adjusted interest cover is relatively low being towards the bottom threshold for a Baa1 rating. As the adjusted interest cover ratio effectively just compares the ratio of the real cost of capital earned to cash interest (see section 6 below for more details) and removes the impact of fast money, for

Copyright © United Utilities Water Limited 2018

8


the notional company with no outperformance and set index-linked debt assumptions there are no real means of improving this ratio without changing the allowed cost of equity.

Therefore, we have assessed the notional company financeability against a Baa1/BBB+ credit rating target. Whilst we assess A3/BBB+ to be the most appropriate rating for a UK water company, we do still consider a Baa1/BBB+ rating to be just about financeable, but with a lower degree of financial resilience.

3.2 Targeted financial ratios and thresholds As stated above, we have targeted credit ratings with Moody’s and S&P and therefore we identified the key financial ratios that those rating agencies use to assess companies in the UK water sector. We have also identified the relevant thresholds for an A3/Baa1/BBB+ rating. The thresholds identified are based on the assumption that the rated entity is a conventionally equity financed company without any structural enhancements and with the presence of shareholders, as we believe these are appropriate assumptions to make for a notional company and also this mirrors our actual company.

Moody’s 22 May 2018 publication “Regulated water utilities – UK: Regulator’s proposals undermine the stability and predictability of the regime”2 includes Moody’s revised generic ratio guidance for the UK water sector on page 5 (included as Figure 3 below). This highlights debt to RCV and adjusted interest cover as Moody’s primary financial ratio assessment for the UK water sector and show A3 rating thresholds of 65% for debt to RCV and 1.7x for adjusted interest cover, Baa1 rating thresholds of 72% for debt to RCV and 1.5x for adjusted interest cover and Baa2 rating thresholds of 80% for debt to RCV and 1.3x for adjusted interest cover.

Figure 3: Moody’s generic ratio guidance for the UK water sector

We understand that whilst Moody’s historically supplemented these two ratios with the RCF to debt financial ratio, this ratio is now of lesser importance and Moody’s no longer maintain specific ratio guidance for RCF to debt.

S&P’s 30 January 2018 publication “New Ofwat Regulations Will Keep U.K. Water Utilities On Their Toes”3 demonstrates that S&P assess the water sector against the following ratios: FFO to debt, FFO interest cover, DCF to debt, FOCF to debt and debt to RCV, which are all shown in table 2 of the publication. However, just one ratio is included in the sensitivity stress scenario shown in chart 3 of the publication (included as Figure 4 below), which is FFO to debt. This supports our understanding that S&P’s most critical financial ratio in assessing the water sector is FFO to debt.

Figure 4 Illustrates that the FFO to debt threshold is 9% for conventionally equity financed BBB+ rated water companies (being Wessex, Northumbrian and Severn Trent), 11% for conventionally equity financed A- rated water companies (being United Utilities) and 7% for conventionally equity financed BBB rated water companies (being Portsmouth).

2 Regulated water utilities – UK: Regulator’s proposals undermine the stability and predictability of the regime 3 New Ofwat Regulations Will Keep U.K. Water Utilities On Their Toes


http://researchinfo.moodys.com/Fl0Pn00Vs0V003I0000X9e0

https://www.capitaliq.com/CIQDotNet/CreditResearch/RenderArticle.aspx?articleId=1987108&SctArtId=447628&from=CM&nsl_code=LIME&sourceObjectId=10407077&sourceRevId=1&fee_ind=N&exp_date=20280201-21:26:11


Figure 4: S&P FFO to debt sensitivity stress scenario

Whilst not evidenced by the same publication, we understand that S&P’s secondary financial ratio is FFO interest cover with a BBB+ threshold of 2.5x but that in recent years with low interest rates and most companies demonstrating high interest cover this has temporarily become less important.

3.3 Rating agency and Ofwat model financial ratio differences and the impact on thresholds

Section 3.2 above demonstrates that to retain A3/BBB+ ratings, a UK water company would need to maintain RCV gearing below 65%, adjusted interest cover above 1.7x and FFO to debt above 9%. However, this is only the case if the financial ratios are calculated in line with the methodology used by the relevant rating agencies.

For financeability testing at PR19 the final methodology sets out the ratios to be assessed and how they should be calculated. The final methodology acknowledges that for FFO to debt and adjusted interest cover the ratios included in the Ofwat financial model are calculated differently from certain rating agencies and therefore also provides “alternative calculations of both ACICR and FFO/Net debt metrics, which reflect slightly different methodologies used by some individual credit rating agencies.”

Whilst minor differences remain, we agree that the adjusted cash interest cover (alternative) ratio and the FFO to net debt (alternative) ratio are materially in line with the Moody’s and S&P methodologies respectively, therefore it is most relevant to apply the rating agency thresholds to these ‘alternative’ versions of the ratios (referred to as ‘rating agency’ versions from now on).

For the ‘non-alternative’ calculation of adjusted cash interest cover and FFO to net debt (referred to as ‘Ofwat model’ versions from now on), we have adjusted the rating agency threshold to take account of the differences in calculation and provide relevant thresholds for the Ofwat model variants of financial ratios.


10


3.3.1 S&P: FFO to net debt threshold calculation:

The main difference between the rating agency and Ofwat model FFO to debt ratio is the deduction of indexation on index-linked debt from FFO in the rating agency version, with no deduction in the Ofwat model version. Whilst there are other minor differences to S&P’s calculation (e.g. the inclusion of pension interest where there is a pension surplus and use of cash tax as opposed to underlying income statement based versions), these are not very material.

Indexation on index linked debt can be estimated as the amount of debt multiplied by the AMP7 average proportion of debt that is index-linked (c47% in our actual structure, 33% in the notional structure) multiplied by our RPI inflation assumption (3%), as the vast majority of index-linked debt under our actual structure is RPI-linked and Ofwat has assumed that the notional company’s index-linked debt is also RPI-linked. Adjusting for this gives the FFO to debt threshold for the Ofwat model version of the S&P FFO to net debt ratio. Figure 5 shows the position for the actual company and Figure 6 shows the position for the notional company:

Figure 5: Calculation of Ofwat model FFO to net debt threshold from the S&P FFO to net debt 7%/9% thresholds for the actual structure

= 7% / 9%

= 7% / 9%

FFO - (Debt * 47.1% * 3%) = 7% / 9%Debt Debt

= 7% / 9% + (Debt * 47.1% * 3%)Debt

= 7% / 9% + Debt * 1.41%Debt

= 7% / 9% + 1.41% = 8.41% / 10.41%

Debt

FFO - indexationDebt

FFO - (Debt * 47.1% * 3%)

FFODebt

FFODebt

FFODebt



Figure 6: Calculation of ‘non-alternative’ FFO to net debt threshold from the S&P FFO to net debt 7%/9% thresholds for the notional structure

Therefore whilst the appropriate threshold for the rating agency FFO to net debt ratio is ≥ 7% and ≥ 9% for both the actual and notional company structures for BBB and BBB+ ratings respectively, for the Ofwat model FFO to net debt ratio it is ≥ 8.4% and ≥ 10.4% for the actual company structure for BBB and BBB+ ratings respectively and ≥ 8% and ≥ 10.0% for the notional company structure for BBB and BBB+ ratings respectively.

3.3.2 Moodys: Adjusted interest cover threshold calculation: The main difference between the rating agency and Ofwat model adjusted interest cover ratio is the deduction of any accelerated revenue from FFO in the rating agency version, with no deduction in the Ofwat model version. Whilst there are other minor differences to Moody’s calculation (e.g. the inclusion of pension interest where there is a pension surplus and use of cash tax as opposed to underlying income statement based versions), these are not very material.

In our business plan submission for both the actual and notional company structure we have accelerated £102m of revenue via PAYG, which is an annual average of £20m (17/18 prices) or £22m (outturn prices). Adjusting for this difference gives the following thresholds for the Ofwat model version of the adjusted interest cover ratio (note these thresholds are only relevant for the current level of PAYG acceleration and would change if more or less were accelerated) with Figure 7 showing the position for the actual company and Figure 8 showing the position for the notional company:

= 7% / 9%

= 7% / 9%

FFO - (Debt * 33% * 3%) = 7% / 9%Debt Debt

= 7% / 9% + (Debt * 33% * 3%)Debt

= 7% / 9% + Debt * 0.99%Debt

= 7% / 9% + 0.99% = 7.99% / 9.99%

FFO - (Debt * 33% * 3%)

FFO - indexationDebt

Debt

Debt

FFODebt

FFODebt

FFO


12


Figure 7: Calculation of ‘non-alternative’ ACICR threshold from the Moody’s ACICR 1.7x threshold for the actual structure

Figure 8: Calculation of ‘non-alternative’ ACICR threshold from the Moody’s ACICR 1.7x/1.5x thresholds for the notional structure

Therefore whilst the appropriate threshold for the rating agency adjusted interest cover ratio is > 1.7x for an A3 rating and > 1.5x for a Baa1 rating for both the actual and notional company structures, for the Ofwat model adjusted interest cover ratio it is > 1.84x for an A3 rating for the actual company structure and > 1.79x for an A3 rating and > 1.59x for a Baa1 rating for the notional company structure.

3.3.3 Moodys: Gearing threshold: Given the adoption of IFRS16 in our PR19 business plan whereby operating leases are on balance sheet and the absence of an accounting pension deficit in our actual company structure, we are comfortable that the calculation of gearing in the Ofwat financial model is materially similar to that used by Moody’s. Therefore it is appropriate to apply Moody’s 65% threshold to the Ofwat financial model version of the ratio for both the actual and notional companies.

3.3.4 S&P: Interest cover threshold: There are some minor differences in calculation between the Ofwat financial model and that used by S&P (e.g. the inclusion of pension interest where there is a pension surplus and use of cash tax as opposed to underlying income statement based versions). However, these are relatively immaterial and, given that this ratio is not a key

Moody's ACICR = 1.7x

= 1.7x

FFO - capital charges + P&L interest - fast money = 1.7xCash interest Cash interest

= 1.7x + PAYG advancementCash interest

= 1.7x + PAYG advancementCash interest

= 1.7x + £22.2m = 1.84x£161.2m

FFO - capital charges - fast money + P&L interestCash interest

FFO - capital charges + P&L interestCash interest

Ofwat ACICR

Ofwat ACICR

Moody's ACICR = 1.7x/1.5x

= 1.7x/1.5x

FFO - capital charges + P&L interest - fast money = 1.7x/1.5xCash interest Cash interest

= 1.7x/1.5x + PAYG advancementCash interest

= 1.7x/1.5x + PAYG advancementCash interest

= 1.7x/1.5x + £22.2m = 1.79/1.59x£237.8m

Ofwat ACICR

FFO - capital charges - fast money + P&L interestCash interest

FFO - capital charges + P&L interestCash interest

Ofwat ACICR



financeability ratio, we assess that it is acceptable to use the 2.5x threshold unmodified for the Ofwat financial model version of the ratio for both the actual and notional companies.

3.3.5 Moodys: RCF to net debt threshold: As mentioned in section 3.2, Moody’s no longer maintain an RCF to debt threshold and this ratio does not seem to be an important ratio to other rating agencies, therefore we have not identified a relevent threshold.

3.3.6 Moodys: RCF to capex threshold: The RCF to capex ratio does not seem to be an important ratio to rating agencies and therefore we could not identify an appropriate threshold.

3.3.7 Overall threshold position: Overall, we assess that the following thresholds are appropriate for use in our financeability assessment:

Table 2: Debt financeability: Financial ratio thresholds A3/BBB+

thresholds for actual company

structure

A3/BBB+ thresholds for

notional company structure

Baa1/BBB+ thresholds for

notional company structure

BBB thresholds for actual company structure

BBB thresholds for notional

company structure

Gearing ≤65% ≤65% ≤72% n/a n/a

Interest cover ≥2.5x ≥2.5x ≥2.5x n/a n/a

Adjusted cash interest cover ≥1.84x ≥1.79x ≥1.59x n/a n/a

Adjusted cash interest cover (alternative)

≥1.7x ≥1.7x ≥1.5x n/a n/a

FFO to net debt ≥10.4% ≥10.0% ≥10.0% ≥8.4% ≥8%

FFO to net debt (alternative) ≥9.0% ≥9.0% ≥9.0% ≥7% ≥7%

RCF to net debt n/a n/a n/a n/a n/a

RCF to capex n/a n/a n/a n/a n/a

3.4 Debt financeability assessment – notional company Table 3 shows our appointed business’ forecast credit metrics for the notional company over AMP7.

Table 3: Debt financeability: Appointed business financial metrics (notional company) 2020-21 2021-22 2022-23 2023-24 2024-25 A3/BBB+

thresholds Baa1/BBB+ thresholds

Gearing 59.9% 59.9% 59.7% 59.8% 60.0% ≤65% ≤72%

Interest cover 4.1 4.1 4.1 4.2 4.2 ≥2.5x ≥2.5x

Adjusted cash interest cover 1.7 1.7 1.6 1.6 1.6 ≥1.79x ≥1.59x

Adjusted cash interest cover (alt) 1.6 1.6 1.5 1.5 1.5 ≥1.7x ≥1.5x

FFO to net debt 10.2% 10.0% 10.0% 10.0% 10.0% ≥10.0% ≥10.0%

FFO to net debt (alt) 9.3% 9.1% 9.1% 9.1% 9.0% ≥9% ≥9%

RCF to net debt 6.2% 6.1% 6.4% 6.4% 6.4% n/a n/a

RCF to capex 92.2% 93.1% 110.7% 79.2% 92.9% n/a n/a

We have targeted a Baa1/BBB+ credit ratings for the notional company. On this basis the key financeability constraints for the notional company is both adjusted interest cover and FFO to debt.


14


As explained in 2.1.1 above these constraints arise due to the mismatch between the regulatory model and the financial statements, which reflect the real return on the RCV asset base in revenue but the full nominal cost of debt in interest expense. As a consequence this depresses the level of reported FFO, adversely impacting FFO based metrics. This impact is exacerbated at PR19 due to the lower levels of real returns with the real cost of debt representing a smaller proportion of the nominal cost compared to PR14.

3.4.1 Financeability constraint 1: FFO to debt

Table 4: Debt financeability: Appointed business FFO to debt ratios pre & post PAYG advancement and revenue profiling (notional company)

Notional company 2020-21 2021-22 2022-23 2023-24 2024-25 BBB+ thresholds

FFO to net debt pre PAYG advancement and revenue re-profiling

9.7% 9.5% 9.7% 9.8% 9.8% ≥10.0%

FFO to net debt post PAYG advancement and revenue re-profiling

10.2% 10.0% 10.0% 10.0% 10.0% ≥10.0%

FFO to net debt (alternative) pre PAYG advancement and revenue re-profiling

8.8% 8.6% 8.8% 8.8% 8.8% ≥9.0%

FFO to net debt (alternative) post PAYG advancement and revenue re-profiling

9.3% 9.1% 9.1% 9.1% 9.0% ≥9.0%

As can be seen from Table 4, without PAYG advancement the notional company’s FFO to debt and FFO to debt (alternative) ratios are below the 10% and 9% required thresholds respectively during the AMP. Therefore the notional company would not achieve a BBB+ rating from S&P, likely being allocated a BBB flat rating which we would not consider financeable. Additionally, a BBB rating from S&P would not be in line with Ofwat’s rating assumptions used in setting the cost of debt component of the WACC guidance (which reflects a 50:50 average of the iBoxx non-financial A and BBB rated 10yr+ indices), being more than one notch lower.

In contrast to adjusted interest cover, this weakening of FFO to net debt due to the reduction in the real cost of capital can be addressed through revenue advancement. Where used moderately, as per our business plan submission, PAYG advancement can be applied whilst maintaining a stable capital structure (measured by debt to RCV) and distributions in line with Ofwat’s assessment of an appropriate level of dividend return (5% per the recent position statement on putting the sector in balance).

Therefore to ensure that the notional company can achieve a BBB+ S&P rating we have advanced £102m of revenue into AMP7.

As can be seen from Table 4, with our proposed PAYG advancement the FFO to net debt ratio is at the 10% lower threshold for most years of AMP7, and the FFO to net debt (alternative) ratio is at the 9% lower threshold in the last year of AMP7, showing that our proposed PAYG advancement is the smallest amount we could propose that would be consistent with achieving a BBB+ rating and therefore financeable. Our customers are supportive of this approach.

Further, in chapter 4 of our AMP7 business plan, we set out the results of stress testing applied to our business plan, which shows that the ‘combined common scenario’ is the most detrimental scenario tested. As Table 5 shows, without the benefit of the proposed £102m PAYG advancement, the resultant underperformance on FFO to debt (i.e. the persistent impact following the initial cost shock) would result in 8.2% and 7.2% for FFO to net debt and FFO to net debt (alternative) respectively for the AMP7 exit point with a downward trend, which corresponds to the required thresholds of 8% and 7% respectively for a BBB rating.

Table 5: Debt financeability: Appointed business FFO to debt ratios under the ‘combined scenario’ pre & post PAYG advancement and revenue profiling (notional company)

Notional company 2020-21 2021-22 2022-23 2023-24 2024-25 BBB thresholds



FFO to net debt under the ‘combined scenario’ pre PAYG advancement and revenue re-profiling

9.3% 8.8% 8.6% 8.4% 8.2% ≥8.0%

FFO to net debt under the ‘combined scenario’ post PAYG advancement and revenue re-profiling

9.8% 9.3% 8.9% 8.6% 8.4% ≥8.0%

FFO to net debt (alternative) under the ‘combined scenario’ pre PAYG advancement and revenue re-profiling

8.4% 7.9% 7.7% 7.4% 7.2% ≥7.0%

FFO to net debt (alternative) under the ‘combined scenario’ post PAYG advancement and revenue re-profiling

8.9% 8.4% 8.0% 7.7% 7.4% ≥7.0%

This ratio output implies that the under the ‘combined common scenario’, our business plan would be taken to the precipice of the minimum investment grade credit rating, which has material impacts for the ongoing financial resilience and future cost of debt for the company. It would leave us extremely vulnerable to further downgrade, e.g. from the various external factors that also affect credit ratings.

It is also notable that the ‘combined common scenario’ does not include the impact of higher interest rates. However, this would be a natural consequence of a fall to a rating of BBB, which we estimate would increase the cost of new debt raised by c0.2% in benign market conditions to over c1.0% in adverse market conditions. This would push the ‘combined common scenario’ FFO to debt ratio below the 7% BBB threshold and into the minimum investment grade credit rating of BBB-, which would be materially divergent from the credit rating implied by Ofwat’s WACC guidance.

For these reasons we consider it necessary to advance PAYG by at least £102m, to ensure that both a) the notional company is financeable on a similar credit rating basis as that implied by Ofwat’s WACC guidance, and that b) there is sufficient headroom in the notional company to avoid falling into the lowest investment grade credit ratings category.

It is also important to note that S&P are the only one of the three rating agencies not (yet) to have tightened its financial indicator thresholds which apply to credit ratings for the UK water sector. This serves to cast further doubt as to the financial resilience of the notional company, unless some additional revenue is advanced, such as via PAYG advancement as we propose in our plan.

Therefore overall, with the c£102m PAYG advancement, the notional company should just meet the relevant thresholds to achieve a BBB+ rating with S&P.

3.4.2 Financeability constraint 2: Adjusted interest cover Ideally, we would have targeted an A3/BBB+ credit rating for the notional company, as we believe that gives a more resilient financeability assessment (see section 3.1). However, as can be seen from Table 5, whilst gearing is comfortably in A3 territory being well below 65%, adjusted interest cover is very low such that the notional company would unlikely to be able to achieve an A3 rating and would actually be at the lower limit of what would be acceptable for a Baa1 rating by the end of AMP7, with both the adjusted cash interest cover and adjusted cash interest cover (alternative) ratios being at the lower thresholds of 1.59x and 1.5x respectively for the final 3 years of AMP7.

Therefore, we have assessed the notional company financeability against a Baa1/BBB+ credit rating target. We still consider this to be just financeable with very limited headroom, but believe that this is a much less resilient position than an A3/BBB+ target.

For adjusted interest cover, as this ratio effectively just compares the ratio of the real cost of capital earned to cash interest4, for the notional company with no outperformance, the resultant ratio is just a function of the cost

4 See appendix 1 to this document that demonstrates this point Copyright © United Utilities Water Limited 2018

16


of capital, inflation, gearing and proportion of index-linked debt assumptions. PAYG acceleration is removed from the adjusted interest cover (alternative) ratio and therefore there is no available means of improving this ratio for the notional company once these assumptions have been set.

Notwithstanding this, we assess that the notional company should be able to achieve a Baa1 rating from Moody’s based on the above gearing and adjusted interest cover ratios, which remain either just above or at the Baa1 threshold during AMP7.

Overall the notional company should be able to achieve a Baa1 rating with Moody’s and a BBB+ rating with S&P (provided neither agency tightens its credit metric thresholds further in respect of the regulated water sector in England and Wales). The financial ratios only just meet the lower thresholds in several years of AMP7 and so any deterioration in the above financial metrics would seriously risk the notional company receiving a rating of BBB flat / Baa2. We do not consider that a BBB flat / Baa2 rating is appropriate for a water company with significant and on-going debt financing requirements, as such ratings would not afford robust access to financing (particularly at times of market disruption) or deliver efficient financing costs compared with retaining BBB+ / Baa1 ratings.

3.5 Debt financeability assessment – actual company Table 6 shows our appointed business’ forecast credit metrics for the actual company over AMP7.

Table 6: Debt financeability: Appointed business financial metrics (actual company) 2020-21 2021-22 2022-23 2023-24 2024-25 Threshold

Gearing 62.1% 61.6% 60.7% 60.3% 60.0% ≤65%

Interest cover 5.8 6.1 6.2 6.2 6.1 ≥2.5x

Adjusted cash interest cover 2.4 2.5 2.5 2.4 2.4 ≥1.84x

Adjusted cash interest cover (alternative) 2.3 2.4 2.4 2.3 2.2 ≥1.7x

FFO to net debt 10.8% 10.8% 10.9% 11.0% 11.0% ≥10.4%

FFO to net debt (alternative) 9.4% 9.5% 9.6% 9.7% 9.7% ≥9%

RCF to net debt 7.2% 7.3% 7.6% 7.6% 7.5% n/a

RCF to capex 111.1% 114.0% 134.2% 94.7% 109.9% n/a

We have been able to target A3/BBB+ credit ratings for the actual company. However, as can be seen from Table 6, notwithstanding that the S&P rating target is one notch lower than Moody’s at BBB+, it is S&P’s key credit metric of FFO to net debt that acts as the constraining credit metric on our AMP7 plan with minimal headroom to maintain BBB+.

This is primarily seen through the FFO to net debt and the FFO to net debt (alternative) ratios. Whilst both of these ratios are above the required thresholds of 10.4% and 9% respectively throughout AMP7, the FY21 and FY22 ratios are relatively tight. These ratios show some headroom to the required thresholds as the size of the PAYG revenue advancement was set to ensure that the notional company is just financeable. Our actual company benefits from a lower cost of embedded debt, resulting in limited but essential headroom for the actual company.

In contrast to the notional company, for the actual company adjusted interest cover is not a financeability constraint. This is because the actual company has the benefit of lower embedded interest costs and a higher proportion of index-linked debt that is treated favourably in the ratio, these elements comfortably outweigh the slightly higher gearing in the actual company.

For the actual company, FFO to net debt was the constraining credit metric for us at PR14 and remains the case for both the alternative and non-alternative variants at PR19 for the reason as set out in 2.1.1. The actual company benefits from a very modest amount of headroom on the FFO to debt ratio compared to the notional company due to the actual company’s lower embedded interest costs. We view this very modest amount of headroom as essential to maintain a degree of resilience in our ratings for the actual company.



For the actual company the financial metrics for an A3 credit rating with Moody’s remain relatively comfortable. The gearing position is supported by our decision to retain a conventional equity capital structure, with a robust 55-65% gearing target, and the adjusted interest cover metrics are bolstered by our relatively high proportion of index-linked debt (c47% on average over AMP7), which is viewed favourably by Moody’s.

Even after applying our proposed PAYG rates, for the actual company the financial metrics for a BBB+ credit rating with S&P are tight for most years of the AMP, particularly towards the start of the AMP. Therefore, whilst we expect the actual company structure to achieve a BBB+ rating, the FFO to net debt metrics show that our plan is finely balanced.

In setting financeability at such a tight margin we have assessed that our proposal results in the lowest achievable customer bill impact whilst being sufficient to maintain a financeable plan (albeit with limited headroom) and this in turn puts greater pressure on the appointed business to deliver operational performance.

If we deliver our plan effectively, meeting our efficiency challenges, then overall we should be able to achieve an A3 rating with Moody’s and a BBB+ rating with S&P (provided neither agency tightens its credit metrics further in respect of the regulated water sector in England and Wales). Any deterioration in the above financial metrics would seriously risk S&P assigning a rating to UUW of BBB flat. We do not consider that a BBB flat rating is appropriate for a water company with significant and on-going debt financing requirements as it would not have as robust access to financing or as efficient financing costs as a BBB+ rating affords.

4 Equity financeability: Maintaining a healthy level of public equity investment

A fair and balanced business plan should provide a fair return to equity investors, taking account of the risks they face. To ensure that we can retain and attract sufficient equity investment to finance our plan and that debt investors, customers and other stakeholders can be confident that there will be a functioning equity ‘buffer’, we need to ensure that the appointed business can earn a sufficient return and that the returns we pay out to our equity investors are sustainable.

Whilst we do not anticpate large injections of equity finance in our business plan, it remains important that equity investors are adequately remunerated. Delivering sufficient and sustainable equity returns is essential to maintaining the confidence of equity investors in a world where capital is easily re-deployed. At times during 2018 listed water companies have traded at a discount to RCV and a harsh cost of equity settlement could increase the risk that equity investors may lose confidence in the sector and withdraw support. Credit investors rely on a well-functioning equity buffer and may not be comfortable lending to the sector in such a scenario. Therefore an adequate cost of equity is important for all providers of finance.

As shown in sections 4.1 and 4.2 we assess both the notional and actual companies to be financeable to equity investors.

4.1 Equity financeability assessment – notional company Table 7 below shows the key equity financeability ratios for the appointed business on a notional company basis over AMP7:

Table 7: Equity financeability: Appointed business financial metrics (notional company) – RPI/CPIH blended real rate

2020-21 2021-22 2022-23 2023-24 2024-25 AMP7 ave

Return on capital employed (building blocks) 3.0% 3.0% 2.9% 2.9% 2.9% 2.9%

RORE 4.5% 4.6% 4.6% 4.6% 4.7% 4.6%

Appointed business dividend cover 0.9 1.0 0.9 1.0 1.0 1.0


18


The average building block Return on capital employed (ROCE) over AMP7 is expected to be 2.9% for the notional company, which shows that the notional company should earn returns just over the vanilla appointed WACC of 2.85% (RPI/CPIH blend real) at the appointed business level. The appointed WACC sits in, but towards the bottom of, the WACC range that our advisors Ernst & Young (EY) deem to be appropriate for the sector over AMP7 (see chapter 9, section 9.4.2 of our AMP7 business plan for more details) and therefore should be considered acceptable to our equity investors.

The average RORE over AMP7 is expected to be 4.6%, which shows that the notional company should earn returns around the appointed cost of equity of 4.57% (AMP7 average RPI/CPIH blend real) at the appointed business level. Whilst this cost of equity sits just below the cost of equity range that our advisors EY deem to be appropriate for the sector over AMP7 (see chapter 9, section 9.4.2 of our AMP7 business plan for more details), this should be strengthened by the cost of debt included in the WACC being above the minimum deemed appropriate for the sector by EY, which will bolster equity returns as financing outperformance along with any other outperformance achieved under the regulatory model. Therefore this ‘strengthened’ cost of equity should be considered acceptable ‘in the round’ to our equity investors.

Dividend cover is an important measure of sustainability of the equity return, and equity investors will start to have concerns if dividend cover consistently drops below around 1.0 times cover, with trend being an important factor. The average dividend cover of 1.0 should just about be considered acceptable by equity investors.

Therefore overall we assess the notional company to be financeable to equity investors.

4.2 Equity financeability assessment – actual company Table 8 below shows the key equity financeability ratios for the appointed business on an actual company basis over AMP7 if our business plan is accepted and efficiently delivered:

Table 8: Equity financeability: Appointed business financial metrics (actual company) – RPI/CPIH blended real rate

2020-21 2021-22 2022-23 2023-24 2024-25 AMP7 ave

Return on capital employed (building blocks) 3.0% 3.0% 2.9% 2.9% 2.9% 2.9%

RORE 4.6% 4.6% 4.6% 4.6% 4.6% 4.6%

RORE including expected financing outperformance on embedded debt

5.3% 5.6% 5.7% 5.6% 5.6% 5.6%

Appointed business dividend cover 1.2 1.2 1.2 1.2 1.3 1.2

The average building block ROCE over AMP7 is expected to be 2.9% for the actual company, which shows that if our plan is efficiently delivered, the business should earn returns just over the vanilla appointed WACC of 2.85% (RPI/CPIH blend real) at the appointed business level. The appointed WACC sits in, but towards the bottom of, the WACC range that our advisors EY deem to be appropriate for the sector over AMP7 (see chapter 9, section 9.4.2 of our AMP7 business plan for more details) and therefore should be considered acceptable to our equity investors.

The average RORE over AMP7 is expected to be 4.6%, which shows that if our plan is efficiently delivered, the appointed business should earn returns around the cost of equity of 4.57% (AMP7 average RPI/CPIH blend real) at the appointed business level. Whilst this cost of equity sits just below the cost of equity range that our advisors EY deem to be appropriate for the sector over AMP7 (see chapter 9, section 9.4.2 of our AMP7 business plan for more details), the low cost of embedded debt in our actual company will result in embedded financing outperformance and should bolster equity returns (as shown by the 5.6% average RORE including financing outperformance). In addition, with the cost of debt included in the WACC being above the minimum deemed appropriate for the sector by EY, this will also bolster equity returns as additional financing outperformance along with any other outperformance achieved under the regulatory model. Therefore this ‘strengthened’ cost of equity should be considered acceptable ‘in the round’ to our equity investors.

The ability of the appointed business to earn the above assumed returns is contingent on the successful delivery of our plan. Our plan includes stretching cost and performance targets, which, if we fail to deliver in full, will reduce the underlying return earned.



Dividend cover is an important measure of sustainability of the equity return, and equity investors will start to have concerns if dividend cover consistently drops below around 1.0 times cover, with trend being an important factor. The average expected dividend cover of 1.2x should be considered sustainable by equity investors.

Therefore overall we assess the actual company to be financeable to equity investors.

5 Ensuring each price control can individually fund its operations

We have performed the bulk of the financeability testing at the appointed business level, as providers of finance will primarily be concerned with the sufficiency and sustainability of financial metrics at that level. However, in line with Ofwat’s final methodology we have also performed high-level headroom checks at the individual price control level.

We note that performing a full financeability assessment of the individual price controls would be extremely challenging. This is because, amongst other reasons, it is not immediately apparent how existing appointed debt should be allocated across the price controls nor what level of gearing would be appropriate for each price control with differing risks and attributes. Therefore as a full financeability assessment is not feasible, any headroom check will be very approximate in nature.

In particular, our headroom check is based on information available within the Ofwat financial model, which means that for the purposes of this headroom check only, we have adopted Ofwat’s assumption in the financial model that the appointed debt is allocated to each price control in proportion to the RCV. We note that for a full robust financeability assessment this would not necessarily be an appropriate assumption.

As there is no independent guidance on how to assess whether the individual price controls are financeable and external investors are only concerned with the appointed business position, we have followed Ofwat’s proposals set out in the final methodology. Therefore we have followed the methodology in considering whether the wholesale price controls “support financial ratios at a level equivalent to an investment grade credit rating”. In the final methodology Ofwat states that it does not “necessarily expect each control to have the same level of financial headroom”, we have interpreted this to mean that Ofwat will test the financial ratios against thresholds that are set one notch worse than the level required for the appointed company. Therefore we have compared the financial ratio output to financial ratio thresholds for a Baa2/BBB flat rated water company.

As is shown in sections 5.1, 5.2 and 5.3 below we believe that each individual price control is sufficiently financeable as part of the appointed business.

5.1 Wholesale price controls – notional company For the notional company our financeability constraint at the appointed level is FFO to debt. Therefore in performing a high-level headroom check at the individual price control level we have focused on this ratio.

In assessing the level of financial headroom required at each individual price control we have we have interpreted Ofwat’s proposed methodology that as these are not separate businesses, the financial ratio output should be tested against a lower level of financial headroom, as long as the appointed business retains sufficient headroom overall (as has been confirmed above). Therefore we have used a lower threshold of 7.0% FFO to debt (alternative) for each individual price control, which we assess to equate to a BBB flat rating from S&P (see 3.2 above for details on how this threshold was determined).

Table 9 shows the FFO to debt (alternative) ratio that each of the wholesale individual price controls is expected to achieve under the notional company. Overall whilst there is variation between each price control, as the FFO to debt (alternative) ratio exceeds 7% on average for each price control, we assess that each individual price control would likely support financial ratios at a level equivalent to a rating of BBB flat from S&P and therefore is sufficiently financeable as part of the appointed business, in meeting the investment grade criteria.


20


Table 9: Individual wholesale price control financeability (notional company): FFO to debt (alternative) ratio 2020-21 2021-22 2022-23 2023-24 2024-25 AMP7 ave

Water resources FFO to debt (alt) 6.9% 7.2% 7.3% 7.5% 7.4% 7.2%

Water Network Plus FFO to debt (alt) 10.0% 9.5% 9.5% 9.9% 10.3% 9.9%

Wastewater Network Plus FFO to debt (alt) 8.2% 7.9% 7.8% 7.5% 7.3% 7.7%

Bioresources FFO to debt (alt) 15.5% 16.0% 17.0% 18.6% 20.3% 17.5%

5.2 Wholesale price controls – actual company For the actual company our financeability constraint at the appointed level is FFO to debt. Therefore in performing a high-level headroom check at the individual price control level we have focused on this ratio.

As for the notional company in section 5.1, in assessing the level of financial headroom required at each individual price control we have interpreted Ofwat’s proposed methodology that as these are not separate businesses, the financial ratio output should be tested against a lower level of financial headroom, as long as the appointed business retains sufficient headroom overall (as has been confirmed above). Therefore we have used a lower threshold of 7% FFO to debt (alternative) for each individual price control, which we assess to equate to a BBB rating with S&P (see section 3.2 for details on how this threshold was determined).

Table 10 shows the FFO to debt (alternative) ratio that each of the wholesale individual price controls is expected to achieve under the actual company if our plan is accepted and efficiently delivered. Overall whilst there is variation between each price control, as the FFO to debt (alternative) ratio exceeds 7% on average for each price control, we believe that each individual price control would likely support financial ratios at a level equivalent to a rating of BBB from S&P and therefore is sufficiently financeable as part of the appointed business, in meeting the investment grade criteria.

Table 10: Individual wholesale price control financeability (actual company): FFO to debt (alternative) ratio 2020-21 2021-22 2022-23 2023-24 2024-25 AMP7 ave

Water resources FFO to debt (alt) 7.0% 8.1% 8.5% 8.9% 8.8% 8.2%

Water Network Plus FFO to debt (alt) 10.1% 10.0% 10.2% 10.8% 11.3% 10.5%

Wastewater Network Plus FFO to debt (alt) 8.3 % 8.2% 8.2% 8.0% 7.8% 8.1%

Bioresources FFO to debt (alt) 15.3% 16.7% 18.0% 20.0% 22.1% 18.3%

5.3 Residential retail price control – actual and notional company The usual financial ratio analysis is not available for the retail price control given the retail business has no RCV and therefore the Ofwat financial model allocates no debt to that price control. Therefore in assessing the financeability of the individual residential retail price control on an actual and notional company basis we have interpreted Ofwat’s proposals of checking “each control can generate sufficient cash flow to service its working capital needs” as principally checking that net cash flow is expected to be positive on average over AMP7.

We note that the net cash flow available to the residential retail price control primarily reflects the proposed 1% margin, which sits within our advisor’s (EY) recommended range (see chapter 9, section 9.4.2 of our AMP7 business plan for more details).

Table 11 shows that the net cash flow is positive on average over AMP7 for both the actual and notional company and therefore we assess the residential retail price control to be sufficiently financeable as part of the appointed business.



Table 11: Individual residential retail price control financeability (actual and notional company): net cash flow 2020-21 2021-22 2022-23 2023-24 2024-25 AMP7 average

Residential retail net cash flow (actual company)

£19m £13m £13m £11m £10m £13m

Residential retail net cash flow (notional company)

£19m £14m £14m £13m £12m £14m


22


6 Appendix 1: Adjusted interest cover ratio The below analysis looks at Moody’s adjusted interest cover ratio and on a simplified basis (i.e. very minor items/adjustments such as movement in provisions, other income, etc. have not been considered) and seeks to identify the key drivers of the ratio. The ratio can be simplified down to a relationship between the cost of equity, cost of debt, gearing, inflation and index-linked debt proportion.

Therefore only changes in those metrics will result in changes to the ratio output.

Note the below analysis has been set out for the notional company as it includes the 33% index linked debt proportion assumption.

ACICR = FFO - RCV run off - IRE + P&L interest no indexation > ThresholdP&L interest no indexation

{FFO ≈ Operating profit + depreciation + IRE - fast money - P&L interest no indexation - tax}

ACICR = (Operating profit + depreciation + IRE - fast money - P&L interest no indexation - tax) - RCV run off - IRE + P&L interest no indexation > ThresholdP&L interest no indexation

ACICR = Operating profit + depreciation - fast money - tax - RCV run off > ThresholdP&L interest no indexation

{Operating profit ≈ Revenue - opex - depreciation - IRE}

ACICR = (Revenue - opex - depreciation - IRE) + depreciation - fast money - tax - RCV run off > ThresholdP&L interest no indexation

ACICR = Revenue - opex - IRE - fast money - tax - RCV run off > ThresholdP&L interest no indexation

{Revenue ≈ WACC * RCV + opex + IRE + fast money + RCV run off + tax}

ACICR = (WACC * RCV + opex + IRE + fast money + RCV run off + tax) - opex - IRE - fast money - tax - RCV run-off > ThresholdP&L interest no indexation

ACICR = WACC * RCV > ThresholdP&L interest no indexation

{P&L interest no indexation ≈ Debt * nominal cost of debt - index linked debt * relevant inflation}

ACICR = WACC * RCV > Threshold(Kd nominal * RCV * gearing) - (RPI * 33% * RCV * gearing)

ACICR = WACC * RCV > Threshold(Kd nominal - [RPI * 33%] ) * RCV * gearing

ACICR = WACC > Threshold(Kd nominal - [RPI% * 33%] ) * gearing

{Kd nominal ≈ Kd real + inflation}

ACICR = WACC > Threshold([Kd real + inflation] - [RPI * 33%] ) * gearing


23

Document Reference: S7003 - United Utilities · 2018. 9. 1. · Chapter 9: Supplementary Document -...

Documents

Transcript of Document Reference: S7003 - United Utilities · 2018. 9. 1. · Chapter 9: Supplementary Document -...